Incubator Funds Are An Attractive Strategy

February 10, 2011 | By: Robert A. Green, CPA

(Note, we invented this concept in early 2000s and have set up hundreds of incubator funds since. When we published this blog, we were not offering assurance (audit/attest) services, so we could be involved with assisting on development.)

Update on June 7, 2011:
Our outside attorney Brent Gillett takes a more conservative tack with “multi-member incubator funds”, where the owner/manager wants to admit close friends and family too, but without compensation. To better protect the owner/manager against potential claims raised by close friends and family and to give investors additional information warranted, Mr. Gillett’s law firm prefers to use investment management documents, minus the compensation clauses. He explained it to one client below.

Per Mr. Gillett, “Given that your initial investor will be passively involved in the business, you may want to consider our multi-member incubator fund structure that can accommodate investments from outside investors. We can establish this kind of investment vehicle for a flat fee of $7,500. In this case, we would essentially deliver offering documents with the same disclosures and corporate governance that would be contained in the documents for a full-fledged hedge fund but with all of the fee language removed from the documents.”

The incubator fund described below should be modified for owner/manager only. We will edit and update this blog to include the “multi-member incubator fund.”

The below article will be updated soon to reflect the above change of course.

Many traders dream of having their own hedge-fund business but only a small percentage of them actually take the plunge. Why do would-be fund managers hesitate? Probably the biggest reason is start-up costs, often financed by the adviser/founder. Advisers probably can’t rely on investors to contribute toward fund expenses until after they successfully raise money and get fund operations underway, and that can take some time.

In addition to paying between $12,000 and $20,000 to form a full-fledged hedge fund, the new fund manager must plan on accounting and tax preparation for the first year of operations, running anywhere from $1,000 per month for accounting to $4,000 per year for annual income tax preparation (including investor K-1s). Both the start-up and operating costs may seem quite high, especially for a trader who doesn’t yet have investors lined up to help cover these costs.

The GreenTraderFunds incubator fund strategy and package is a great solution to this important start-up cost issue. Incubator formation costs with our attorneys in phase I are only around $3,000. Also, our CPAs perform accounting with performance record for around $1,000 per quarter, and year-end tax preparation for approximately $2,500. That’s a huge savings for the adviser versus starting out with a full-fledged hedge fund.

The main value of this incubator fund strategy is to generate a historical performance record for the fund before spending the lion’s share of the expenditures for accommodating outside investors. You can scale up to a full-fledged hedge fund, or scale down to a personal trading business entity.

It’s difficult to attract outside investors without a good trading performance record, otherwise known as a track record. Institutional investors also want to see a good management and business record of success. They skip start-up managers who have not yet proven themselves as business people, and avoid fledgling managers who may not survive the next down trend.

Although a trader may have lots of experience, it is quite likely that under federal securities and futures laws, he will not be able to use quantitative measures of his success to attract potential investors in his new fund. Showing past and prior performance may be allowable under certain restrictive conditions and with using the appropriate disclaimers and disclosures. Keep in mind that prior performance may be apples and oranges compared to a new fund’s trading program too. It’s important to discuss these matters with attorneys experienced in investment management.

Our GreenTraderFunds incubator fund plan deals with these issues. We discuss prior and past performance and how it may or may not be useable. We help devise a trading program for attracting investors later on that’s both realistic and appropriate for investors. Our CPAs and accountants prepare a historical performance record for the incubator fund to be used later on in the full hedge fund documents.

Starting your hedge fund business with an incubator fund can save you over $20,000 during your first year of operations. A full-fledged hedge fund formation, with 12 months of accounting and year-end tax preparation, might cost approximately $30,000 with GreenTraderFunds (a great price). The second year’s accounting and tax will cost approximately $18,000. The GreenTraderFunds incubator fund package costs approximately $9,500 during your first year of operations, and $6,500 in the second year.

Our plan allows you to create a stellar — and marketable — performance record that conforms to all industry and accounting standards. When you are confident that investors are ready to join, you can engage GreenTraderFunds to prepare your investor offering documents and other legal paperwork, using our outside attorneys.

Choosing the wrong team can be a nightmare. Some attorneys are overworked, others sell cookie cutter documents and some can be very difficult to deal with. Attorneys may be done with you when they complete the documents, but GreenTraderFunds sticks with you for the life of your business in many areas of your operations. Some websites offer a document service, but they don’t have attorneys to review the documents, which can lead to trouble. Other sites promise a full solution, but they don’t have the experienced attorneys and CPAs. We have earned the trust of our clients since the founding of Green & Company CPAs in 1983.

Lower start-up costs
Most law firms want to sell you the blue prints and build the hedge fund all at once; they make more money that way. At GreenTraderFunds, we place our clients first and customize a flexible plan that allows you to build your fund in two separate phases. By using our incubator fund strategy, you break down the start-up process and related costs while avoiding redundancy: The two-step process usually costs no more than doing everything at once. We also design the fund with accounting and tax strategies in mind too. Some attorneys have complex terms that are hard to account for, which raises your fees.

• Phase I: Incubator. Create your hedge fund and management company (if needed) as legal entities. You begin building the fund’s performance history by trading with your own funds. This phase usually costs around $3,000. These figures are for setting up onshore funds (you pay state filing fees directly); the price for offshore entities is somewhat higher (and involves the use of offshore legal counsel).

For approximately $1,000 per quarter, GreenTraderFunds will prepare your fund accounting, which includes the performance record. We use FundCount software; your cost is a small license fee. FundCount has fantastic reports; we design the entire reporting system with you and our attorneys. We prepare your annual income tax returns for the fund and the management company. We can also prepare your individual income tax returns as well, all combined for an attractive price. Many important tax breaks from the fund and management company flow through to your individual tax return, so it’s best to use us for the entire tax preparation work.

• Phase II: Completion. Using our GreenTraderFunds outside attorneys, we prepare your offering documents, investor agreements, and other legal paperwork, and you begin accepting outside investors. For special-purpose funds and offshore funds, we also work closely with some outside law firms to provide Phase II services at excellent prices and customer service. We call the shots on tax strategies and much more, so their work fits nicely into our designs.

You can use the incubator strategy with any type of hedge fund. Whether you have a securities fund, commodities/futures fund, forex (currency) fund, onshore, offshore, master/feeder fund, or mini-master/feeder, our incubator strategy can save lots of money in your startup period.

The cost advantage of our Incubator Fund strategy is tremendous. Of course, if you already have investors lined up, you’ll want to skip the incubator phase and have the complete fund set up all at once. However, if you would prefer to move ahead in two steps, the initial cost savings are significant.

Separately managed accounts
Some of our clients prefer to start their investment management business as separately managed accounts rather than a hedge fund. We advise clients on licensing, investment adviser registrations, regulations, accounting methods, tax and business matters. We can form their management company, handle their investment adviser registrations, structure and prepare their advisory agreements, handle their investor accounting and offer tax advice to their investors. We have everything you need for separately managed accounts, with both onshore and offshore investors.

Establish a marketable track record
Unless you’re well known as a successful trader in the financial services industry, with some pedigree, chances are you won’t attract investors into your hedge fund until you can boast an excellent performance record. Of course, if you are thinking of starting a hedge fund, you probably have already had success trading your own accounts or trading professionally. Although prior experience in the markets is very valuable in many ways to a hedge fund manager, one thing it usually cannot provide are hard figures that can be presented to potential investors. Securities laws make it very difficult to use a manager’s prior performance figures to promote a new fund.

The problem with advertising prior performance is the fund manager must show that it is truly representative of what an investor could reasonably expect from the fund. Quite simply, the manager must demonstrate that prior apples are equivalent to present oranges. This is not easy. Trading one’s own personal account or trading as part of a team at a large hedge fund are significantly different from trading in a startup hedge fund.

Creating a prior performance record is difficult and costly. Prior performance records must be audited for accuracy in accordance with GAAP (Generally Accepted Accounting Principles) and verified according to the standards established by the Chartered Financial Analyst Institute (AIMR-PPS and GIPS). The cost of hiring a specialized firm to perform verifications according to CFA Institute standards is quite high. An even greater obstacle, however, is that attorneys are very reluctant to allow the figures to be used in offering documents. Even if you pay accountants to verify that your figures conform to GAAP and AIMR-PPS / GIPS standards, most attorneys still will not include these prior performance records in offering documents because it exposes them to potential litigation from disgruntled investors.

If you have a great prior record and you plan to use the same trading program and environment in your new fund, it may well be worth the effort and cost to pursue this option. You will have to document that your prior trading strategies and working environment are very similar to your future fund trading strategy and environment. In the majority of cases, however, prior performance simply is not representative. And when it is, it is still quite possible that the potential benefits of verifying prior performance do not justify the associated trouble, expense and potential legal exposure.

Happily, the incubator fund is an attractive solution to the prior performance problem. Not only is our incubator fund economical, it generates a historical fund performance record that can be used to attract potential investors. Unlike prior performance — the manager’s investment success prior to starting the fund —historical fund performance doesn’t require verification. The historical performance record of the Incubator Fund is the record of the fund itself.

The bottom line is the majority of those wishing to start a hedge fund are better off skipping prior performance and setting up an Incubator Fund. If you want to avoid dealing with the cost, uncertainty and risk of crafting a prior performance record, you can use an incubator fund to generate the historical performance record that will appear in the fund’s offering documents. You only need a regular annual financial audit in accordance with GAAP. And even if you change the fund’s trading strategy in the future, there is no requirement for verification to CFA Institute standards.

An incubator fund is flexible
Your life is easier during the incubator process. Since you don’t have investors in your incubator phase, it’s much easier to prepare your accounting and NAV reports. There are no complex investor-level accounting issues. Annual tax preparation is also a snap; it’s almost as easy as preparing tax returns for any trader entity. This saves you money and reduces your work and time with our professionals. Since most complications arise when investors come into the fund, an incubator fund can save you many headaches while you are getting your fund’s business operations in order.

You have time to fine-tune your business plan with an incubator fund. When your incubator fund is successful and you’re ready to meet with prospective investors, it’s time to complete your hedge fund business plan and incorporate it into your offering (disclosure) documents. With the time afforded you in the two-step process, you can benefit from hindsight and experience. Maybe you want to change brokers, take soft dollars (or skip them), or change other operations like management team, systems and more. Since you can tweak your hedge fund business plan before preparing your offering documents, those documents will be more representative of your revised operations than if you created them on day one. Since these offering documents are the way you fulfill your disclosure obligations, the incubator approach provides added legal and compliance protection.

The incubator can be valuable even if you decide not to complete the hedge fund. If the incubator fund is successful and can attract outside investors, you will probably decide to move forward with a hedge fund and management company. If, however, you decide not go ahead and complete the fund, you can still take advantage of the entities created in the incubator phase, since they’re designed to accommodate business trading as well as hedge fund trading. You can use one or both of these entities to gain important tax benefits, such as retirement and health insurance deductions. Business traders often need an entity to create “earned income” in order to deduct contributions to retirement and health-insurance plans. Learn more about GreenTraderTax business entity tax strategies and retirement-plan strategies. This built-in contingency plan helps ensure that you receive the maximum value for every dollar spent with us.

The incubator fund allows you to start big or small. Many traders ask about the amount of money they should start with in their incubator fund. There is no minimum investment, though you probably will want to start with at least $25,000, which is the minimum required to establish a pattern day-trader account at a direct-access broker. To attract serious outside investors, you will want to consider trading $100,000 to $1,000,000 or more.

Incubator fund restrictions
Under federal and state laws, you’re not allowed to accept compensation in any form from investors, including yourself, during the incubation period. Nor can you accept funds from outside investors, except (in limited cases) from family and close friends. It is permissible to charge investors (and your own and related accounts) for their share of expenses, such as brokerage and bank fees or professional fees, incurred by the incubator fund while they were a member. Since you’re subject to fiduciary duty rules even with non-paying investors (which means you can be sued for losing their money), you should consult with an attorney before accepting other people’s money into your incubator fund.

The bottom line
Starting your own hedge-fund business can be your ticket to financial freedom. However, it is a reality that most new businesses, including hedge funds, fail in the first year of operations. As you start your fund, plan wisely. If you decide on a low-cost, low-risk vehicle for getting your fund off to a solid start, talk to us about an incubator fund.